Wash Sale Rule
The Wash Sale Rule (IRC §1091) disallows capital loss deductions if substantially identical securities are purchased within 30 days before or after a sale. While disallowed losses are usually added to the new basis, IRA purchases can cause permanent loss of the deduction. Careful timing and strategies such as the double-up or options approach can help investors avoid these pitfalls and preserve tax benefits.
Understanding the Wash Sale Rule: How to Avoid Losing Your Tax Deduction
When investors sell losing stocks or mutual funds, the goal is often to claim a capital loss deduction on Schedule D and use it to offset capital gains or up to $3,000 of ordinary income. However, this isn’t always possible. The Wash Sale Rule (IRC §1091) disallows a capital loss deduction if the taxpayer purchases “substantially identical securities” within 30 days before or after the sale.
This rule applies to stocks, mutual funds, and even options. Securities dealers are exempt if losses occur in the ordinary course of business, though this rarely applies to individual investors.
What Happens to the Disallowed Loss?
The good news is that the loss isn’t gone forever. Instead, it is added to the basis of the newly purchased security, and the holding period is extended to include the original security’s holding period. This means future gains could still benefit from the adjustment.
Special Considerations
Timing matters: A purchase in early January can trigger a wash sale on losses taken in December. Investors must review transactions across both years to avoid surprises.
Spouses and related parties: If a spouse or a controlled corporation buys the same stock within the 61-day window, the Wash Sale Rule can apply. The IRS extends this interpretation in Publication 550, though some argue the legal basis is weak.
IRAs and 401(k)s: According to Rev. Rul. 2008-5, if an IRA buys substantially identical securities within the restricted window, the loss is permanently disallowed — and cannot be added to the IRA’s basis. This harsh result is based on outdated case law, and many tax experts believe the IRS’s position is overly aggressive.
Strategies to Avoid Wash Sale Issues
The Wash Sale Rule typically matters when an investor wants to harvest tax losses but still keep exposure to the same security. Two common strategies are:
Double-Up Strategy
Buy the same number of shares before selling the original lot. For example, purchase 1,000 additional shares in November, then sell the original 1,000 shares in late December (at least 31 days later). This way, the loss is deductible while maintaining the same investment exposure.
Options Strategy
Instead of buying shares, purchase call options on the stock. For instance, buy call options in November, then sell your existing stock in December (after 31 days). This avoids triggering a wash sale while allowing you to stay positioned for potential gains.
Final Thoughts
The Wash Sale Rule is a common trap for investors who harvest losses at year-end. By understanding how basis adjustments work, reviewing spouse and IRA transactions, and using strategies like the double-up or options method, taxpayers can protect their capital loss deductions and optimize tax savings.